The year-end outlooks - common narratives but unknown catalysts

My mailbox has been filled with end of year outlooks. Some are short and very general while other are quite long and detailed. Some are just wordy overviews of what to expect while others have a large number of supporting data and graphs. Most this year are surprisingly the same. 

Global economic growth will pick-up albeit still muted. Asset performance will be positive but lower after the wildly successful 2019. Non-US stock markets should improve on a relative basis and equities will still outperform bonds. These forecasts can all be condensed into the simple comment the financial world will be normal without too much excess either positive or negative. If you believe in long-term risk premia, the market will behave as expected. There are some cautious comments but without much specificity. 

What are missing from these forecasts are the catalysts for change, or the assumptions for the new world. Now, I don't have the magic forecasts for 2020, but I do know that any forecast is based on what will be assumed. Any change from the current benign economy will require a catalyst or surprise event. Shocks drive change, so an effective forecast will walk through different shock scenarios. A forecast narrative even for a stable growth scenario requires assumptions and drivers. 

The status quo forecast, for example, requires some of the following conditions:

• Strengthening or stable PMI 
• Improved manufacturing growth and trade
• No further trade wars rhetoric or action 
• No geopolitical surprises 
• No BREXIT surprises 
• No election surprises (policy changes)
• Continued stable volatility 
• Increased earnings or increased equity valuations 
• Continued China growth 
• Stable Fed policy and "Powell Put" if markets sell-off
• Inflation surrounding the 2% corridor
• Continued liquidity from other central banks 
• Leverage debt slowdown

Yes, this seems like a Goldilocks economy but for 2020 to meet forecast expectations a lot of things have to go right and very little can go wrong. Even this environment is no guarantee for similar returns in 2020 over 2019. Walk through your list of catalysts and assumptions of what has to go right or wrong and then make your bets.

Gradualism not sudden change is good for markets

Journalism by its very nature conceals progress, because it presents sudden events rather than gradual trends. Most things that happen suddenly are bad: a war, a shooting, an epidemic, a scandal, a financial collapse. Most things that are good consist either of nothing happening — like a nation that is free of war or famine — or things that happen gradually but comp­ound over the years, such as declines in poverty, illiteracy and disease.

- Steven Pinker in FT "Steven Pinker: What can we expect from the 2020's?"

Steven Pinker was talking about general progress, but his comments should resonant with any market investor. Anything bad that will happen to markets will be quick, unexpected, and sudden. Any good that will happen in 2020 will occur slowly. A slight improvement in growth, an increase in earnings, or continued limited volatility. 

Unfortunately, investors, like everyone, have a negativity bias. Events with a negative slant will have a greater psychological effect on investors. This negative bias applies to our attention, learning, and memory. Bad things have a greater impact on our decision-making as well as what we remember. We likely remember the large negative events over the last decade over the long-term good. Of course, we want to avoid loss but it is as important to focus on the gradual positivism that is seen in the economy and markets. 

What financial forecasters can learn from weathermen

Weathermen are considered the best forecasters for any field of study. We know because there is a lot of data for testing and weathermen are good at using probabilities. They often provide a probability forecasts so that phrases like "there is a 75% chance of rain" can actually be tested.

Studies have shown that a seven-day forecast can accurately predict the weather about 80 percent of the time and a five-day forecast can accurately predict the weather approximately 90 percent of the time. However, a 10-day—or longer—forecast is only right about half the time. 

Their forecast accuracy should be kept in mind when we hear end of year forecasts from many market strategists. The likelihood that their prognostications will prove correct is slim.  Financial forecasts are notoriously poor. 

Models that try and explain financial data have R-squares that are often in the single digits, and while models actually improve over the longer-run, the amount explained is still low. Out-of-sample predictions show further declines as measured y mean squared error. Likely, there is evidence that even a model with low explanatory poor has some value for asset allocation; nevertheless, we should place limited weight on these year-end strategy pieces. 

What should these end of year outlooks tell us? I would highlight three things that should be useful.

1. Provide analysis of where we have been over the last twelve months. A good end of year strategy piece should recap the year and explain why any forecasts were in error or were correct. What surprised investors and why should this not occur again in 2020. 

2. Highlight different issues that can cause change in the coming year. The year-end outlook should focus on the potential issues that will change the current state of markets, the market catalysts. 

3. The outlook should consider different scenarios and outline what will be the impact if those scenarios are realized. The scenarios can be in the form of a base, optimistic, and pessimistic case.  Each should be given some probability weight. 

Most important is that the outlook has precision and some measure of likelihood. Forecast should also be given a path and a horizon. It is not enough to just say that stocks will do better than bonds, or credit spreads may widen. Precision requires thought.  Be like the weatherman who will give a specific forecast, a likelihood, some rationale for what may go wrong, and a narrative for why the forecast will work.

Bob Rubin and principles of decision-making

Bob Rubin, former US Treasury Secretary, may have the most succinct set of principles for good decision-making. The following are excepts from his Penn commencement speech 20 years ago. It is hard to add to his four principles. The hardest part may just be following the rules.

 I have been guided by four principles for decision-making.

1.     First, the only certainty is that there is no certainty.

2.     Second, every decision, as a consequence, is a matter of weighing probabilities.

3.     Third, despite uncertainty, we must decide and we must act.

4.     And lastly, we need to judge decisions not only on the results, but on how they were made.

First, uncertainty… If there are no absolutes then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision.

Second, a healthy respect for uncertainty, and focus on probability, drives you never to be satisfied with your conclusions. 

Third, being decisive in the face of uncertainty. In the end, all decisions are based on imperfect or incomplete information. But decisions must be made — and on a timely basis — whether in school, on the trading floor, or in the White House.

Fourth, and finally, judging decisions. Decisions tend to be judged solely on the results they produce. But I believe the right test should focus heavily on the quality of the decision making itself.

Time and again during my tenure as Treasury Secretary and when I was on Wall Street, I faced difficult decisions. But the lessons are always the same: good decision-making is the key to good outcomes. Reject absolute answers and recognize uncertainty. Weigh the probabilities. Don’t let uncertainty paralyze you. And evaluate decisions not just on the results, but on how they are made.

Treasury Secretary Robert E. Rubin Remarks to the University of Pennsylvania Commencement Philadelphia, PA

5/17/1999 

History has not been kind to the troika of Greenspan, Rubin, and Summers. Rubin did not see the technology bubble coming. His leadership at Citibank did help the bank prepare for the Financial Crisis. He was good manager with an immediate crisis but perhaps not at seeing the potential for a crisis. However, that does not diminish his framework for decision-making. The framer may not always be effective following their advice. 

Stocks lead bonds and that is helpful for allocation decisions

Thinking about cross-asset sector rotation decisions requires analysis of the lead-lad relations between asset classes. One key relationship is between credit and equity. The question is whether past stock returns can tell us something about future credit spread behavior, returns after accounting for the underlying Treasury returns.

The Merton model for pricing corporate debt tells us that the value of the firm can be viewed as a combination of options representing debt (put options) and equity, the residual value of the firm, (call option). If there is a shock to the equity of the firm, there should also be an impact on the credit-worthiness of debt. The same could be said if there is a shock to debt albeit to a lesser extent since spreads represent a credit and default premium. 

The lead-lag return relationships have been explored by  a number of researchers, see more recently "The lead-lag relationship between the stock and the bond markets" by Konstantinos Tolikas. While there is not complete agreement, the evidence does point to the fact that equity returns lead debt moves as measured by cross correlations and Granger causality tests. Now, both stocks and bonds can react to a common factor, but the speed of adjustment seems to be faster in equity markets.

The strength of this relationship will vary across the credit spectrum. Equity returns lead high yield bonds but not as strongly for investment grade bonds. High yield debt which has a higher default premium will be more sensitive to any change in underlying equity returns. The author looks at bond indices for his testing, but points out that while there may seem to be exploitable profit opportunities, they may not positive after accounting for all transaction costs. 

We have looked at the relationship using credit fixed income ETFs minus Treasury returns and found there is a positive return relationship for both investment and high yield indices; however, the impact is more meaningful intra-month. Longer-term there is positive relationship with past equity returns albeit not at the levels of significance normally used for testing (.05 p-value).

Nevertheless, global macro should watch the relationship between stocks and bonds to exploit credit spread opportunities. Large stock sell-offs will signal poorer credit health for firms. From an alternative risk premia perspective, credit premia will be aligned with equity premia. Holding both credit and equity premia may be closely integrated, so care should be taken when trading in both ARPs to find their uniqueness.   

Dividend yield - Carry the day over Treasuries?

Dividend yields (D/P), as measure by the SPY benchmark, may seem attractive relative to bonds, but be careful and look qt these alternatives on a risk-adjusted basis. 

Carry is expected dividend yield for equities and the expected yield for bonds minus the risk free rate of return when there is no change in underlying asset prices. The "carry" or stand-alone dividend yield is 1.89 which is right at the same place as 10-year Treasury yields.  On a risk-adjusted basis, the equity versus bond carry is similar, (12% SPY volatility versus 11% 10-year Treasury volatility).

The dividend yield is at some of the best levels in decades versus Treasuries, but the longer-term history including the first half of the 20th century, suggests that dividend yields can be much higher than bond yields. That is ancient history relative to our chart which shows the great Treasury yield advantage.

A key driver for the difference in carry yields is volatility. When  long-term bond volatility has been high relative to equities, bond yields will exceed dividend yields. When equity volatility is high on a relative basis, dividend yields will exceed bond yields. After accounting for volatility, bond and dividend yields will be highly correlated. (See the older Financial Analyst Journal paper "Stocks versus Bonds: Explaining the Equity Risk Premium" by Cliff Asness.) 

The low relative dividend yields to bonds may have more to do with relative volatility and overall low bond yields rather than any signal on valuation. That said, in the longer-run returns are more driven or comprised of dividend yields, so low D/P will suggest that future equity returns will be lower than during periods of high D/P. There can be individual equity dividend yield opportunities which can be exploited by rank ordering choices, but the equity benchmark does not offer any opportunities at current relative volatilities.

Hedge funds seem to be afraid of taking risks - What should investors do?

Are hedge funds just not taking enough risk? A new 2020 theme is that investors want hedge funds to take more active bets and generate more alpha. A good hedge fund may have an attractive information ratio but a low volatility and not enough absolute return. That may be fine but if the return is below a pension's discount rate, it may not truly help the portfolio. Of course, there will be diversification benefits, but investors are looking for return. 

A report from Willis Towers Watson "Hedge Funds: A New Way" touches on some of these issues in the more competitive and rapidly changing hedge fund world. Hedge funds have been disappointing investors on a number of fronts. While there are many successful funds, the industry is going through growing pains as it transitions into larger developed firms from smaller craftsman funds.

The hedge fund alpha, on average, has fallen close to zero with limited volatility as measured by Willis Towers Watson. 

There are a number of global hedge fund issues that are affecting performance, investor demand, and industry confidence.

• The firms - As hedge firms have gotten bigger, there is greater emphasis on enterprise value and smoothing management and incentive fees and less focus on high absolute returns. The impact of this business focus is that less risk is being taken. There is a strong desire to hold assets and not swing for the fences and incentive fees. Fund products have been structured to be more diversified and appeal to institutional clients at lower volatility. 
• The macro environment - There has been a significant decline in asset volatility which reduces return dispersion and return potential from trading or making specific active bets. There is more value with just holding market beta in a low dispersion world. 
• Additionally, the hedge fund business has become more competitive with more new firms and traditional money managers moving into the hedge fund space. More capital is chasing what may be limited alpha
• Regulation has also reduced the opportunities for hedge funds to create information advantages.
• Fees - With lower returns, fees have become a larger component of overall return. Investor, of course, want lower fees, and are putting more pressure on managers given there is limited alpha. 
• Financial alternatives - There are more investment alternatives such as alternative risk premia swaps from banks and factor products from traditional managers that have increased the competition and benchmarking of hedge funds. Competition is coming from more than just other hedge funds. 

Are there solutions for investor who do not want to face more low alpha in a changing hedger fund industry?

• The right benchmark - Forming the right benchmark and understanding the risks being taken by hedge funds managers has become a more critical part of the due diligence process for investors. Alpha shrinks when the correct benchmark for a hedge fund is used. If the factor exposures can be measures, the value-added from hedge funds can also be measured.  
• The search for specialists - A big change in the hedge fund industry is the greater desire for specialists or specialty funds especially within larger firms. Investor want to target specific styles and strategies to improve returns from alternatives.
• The fee negotiation - There is greater focus on paying for alpha and not for beta. 
• Alternative risk premia - The development of alternative risk premia swaps have allowed investors to by-pass hedge funds and obtain factor strategy exposures in an efficient manner Investors can get higher leverage and liquidity in the swaps markets. Additionally, the total return swaps based on alternative risk premia are priced at more attractive levels than hedge funds that charge management and incentive fees.  

Investors have to adapt to the changing industry by getting ahead of the structural dynamics. While alpha has been declining, there are simple steps to still gain an investment advantage through adjusting the process of choosing hedge funds, using alternatives to hedge funds, and negotiating for better investment and fee terms. 

Everything cannot do well all of the time - A 2020 theme

In a perfect world market returns are positive and high. In this world, asset allocation decisions do not matter so much. 2019 was an absolute return year. If you held market portfolio for equities, you did well. If you held bonds, you did well. If you held a 60/40 stock/bond blend, you generated double digit returns. Of course, you would have done better with higher equity exposure, but there are few complaints with diversification this year. 

Through November, a 60/40 stock/bond blend of the S&P500 and 10-year Treasury returns has generated a return of over 20%. The chart shows the 60/40 blend since 1928. There were better years when bond yields were higher but 2019 is a great year. It is in the top 20% percent of all years. It is the best year since 1998 and December has not been included.

However, 2020 is more likely going to be a relative value world. Everything is not going to do well, and absolute returns will likely be lower. Call it a year to have tempered expectations. Since 1928, there is slightly less than 50% chance of having a plus 20% return year followed with a double-digit return. The law of averages still applies. The allocation choices made will have a significant impact on portfolio returns and absolute returns will be lower. This is not a dire prediction just a more likely reality.

No longer just "don't fight the Fed" but "live by the Fed"

Fed activity used to be viewed as a signal about the real economy. If the Fed cut rates, it meant that the economy was in trouble, so you had to careful about holding risky assets. Now, the story seems to be different. A rate cut or lowering rates is now an attempt to help risky assets. As an investor, don't worry about any real economic signal. Central banks are sending a signal or behaving in a manner for asset market support. This does not mean that real effects are unimportant, rather the emphasis is on asset price protection.  Consequently, market behavior has adapted. This is not a new argument, but empirical data supports the change in behavior.

This is seen in the provocative chart from BAML. A large switch in correlation has occurred between the pre and post Financial Crisis periods for a wide set of equity sectors. What used to be negative correlations are now positive.  

Now the switch for many of these sectors have only moved from slightly negative to slightly positive, but it is enough to suggest a major change in market perception. Overall, for  42 markets tested, 39 have seen an increase in correlation for the current decade over the last one. 

Trading against old relationships would have been hazardous for an investor's health. Nevertheless, the change is straightforward. The Fed has both implicitly and explicitly signaled that it will not tolerate investors facing risks. Right now, continue to live off the support of central banks. 

Active fixed income - Just overexposing to credit risk versus a benchmark

There is an investment meme that active managers in fixed income are able to beat their benchmarks given the wide variety of strategies employed and the significant dispersion in markets debt offering. There are able to achieve alpha where equity managers fail. 

A closer look suggests that the active managers have a common approach to beating their benchmarks, increase their exposure to credit. After accounting for this added credit exposure, there is no real alpha production. Put differently, hold an active fixed income manager and you are just getting overexposure to credit risk premia. 

This is the conclusion from an AQR paper on fixed income managers across US aggregate, Global aggregate, and Unconstrained managers. (See "Active Fixed Income Illusions" Brooks, Gould, and  Richardson 2019.) This result is not much different than what I have seen from other research that has looked at this issue. The easiest way to beat the benchmark is to load up on exposures that have higher carry through spread risk. Within the credit sector, there is a bias toward BBB-rated debt over higher-rated bonds. 

What is novel about this paper is that it investigates the cost of following this active strategy. Holding more credit will provide higher unconditional returns, but if an investor focuses on the conditional returns during bad equity quarters there is a less benefit from fixed income diversification than what would be received from just holding the benchmark. This result may be surprising but should be expected. If the active managers increase credit exposure, the active portfolio will be more equity sensitivity and less downside protection. 

Now a finer look may reveal active return production, but it seems reasonable to see if there are cheaper ways of getting this excess return through just taking marginal credit risk. Perhaps exposure to a fixed income benchmark index with a credit risk premia overlay could provide value-added, or a Treasury portfolio mixed with a credit index?

The conclusion for fixed income active investing is not different than active equity investing. If the value-added is based on just increasing exposure in what is not in the benchmark, there are less expensive ways of achieving this goal.

Use the BlackRock Geopolitical Risk Index as a substitute for year-end reviews

Investor mailboxes are being filled with year-end analysis and forecasts for 2020. These forecasts usually include some geopolitical analysis on potential risks for next year. Perhaps a simpler approach that may be more rigorous is to follow the BlackRock Geopolitical Risk Index which aggregates market attention across analyst reports, newsfeeds, and social media. The information is scored and aggregated to form an index on key risk topics. It is not the view of one analyst, but the aggregation of all opinions.

This is not a forecast of geopolitical risk, but a measure of attention. Attention can lead to market reactions; however, it can also represent the surprises that lead to large market reactions. As expected trade and US-China competition are the key current geopolitical issues. Overall geopolitical tensions are still high; however, the index has fallen from its peak, so any uncertainty risk premium may be falling. 

The index is worth watching for any investor that focuses on risk-on/risk-off  (RORO) factors. The index is especially helpful when in transition. Rising (falling) geopolitical suggest a time to move from risky to safe assets.

The utter failure of Fed SEP forecasts - Follow what they do, not what they forecast

A key monetary policy story for the year is the complete failure of forward guidance using the SEP (Summary of Economic Projections). The Fed has no special insights and using their forecasts can be dangerous to your economic health. 

At the end of last year, the 2019 forecasts were for higher rates and short rates rising above 3 percent in 2020. The new forecasts are 150 bps lower for 2020 and now have no changes in 2020. No wonder stocks are higher and bonds did well for year. It was a complete reversal of estimates for 2020.

The CPI is now at 2% and there is a lower probability of a recession. There is no special Fed skill at providing guidance to Wall Street or businesses. These projections provide insight to their thinking at a given time but do not represent quality forecasts. 

Will the Fed funds stay the same for 2020? The Fed funds futures is showing at least one cut in 2020. The target rate probabilities suggest a 20% chance of more than one cut. The fact that the SEP is the same as current rates tells us that Fed median guess is now saying that the best estimate for tomorrow is the rate we see today. The Fed rule should be simple, follow what they are doing not what they are forecasting.